Sell Zicom Electronic Security Systems; Edelweiss

Edelweiss report on Zicom Electronis Security Systems:

Zicom Electronic Security Systems declared its FY07 results which were above our expectations in terms of revenues but were below our expectations in terms of profitability. Based on lower than expected profitability, non accrual of service income from video & central monitoring services and continuous increase in selling and distribution expenses going forward we revise our FY08E revenues upwards by 11% and net profit downwards by 36%. We believe that the stock is expensive on our revised FY08E & FY09E estimates and so we downgrade the stock from ‘BUY’ to ‘SELL’

Robust sales growth

Revenues were up 106% y-o-y at Rs 1.54 billion, led by growth in the existing security solutions business and the launch of the retail business during the year. This revenue growth has come on the back of a small revenue base in FY06 and traction in its electronic systems and project business (security solutions group), apart from the kick off of the consumer services group. We expect sales to grow at 34% CAGR over FY07-09E.

EBITDA margins decline

Although raw materials as a percentage of sales have fallen by 200 bps from 69% in FY06 to 67% in FY07 EBITDA margins have declined by 310 bps during the same period. The decline in operating margins can be attributed to increase in employee costs, selling and distribution expenses, advertising and travel expenditure. Employee costs have increased from Rs 54 million in FY06 to Rs 124 million in FY07 on account of the aggressive sales growth strategy and shortage of skilled manpower in the electronic security industry. Advertising expenses increased from Rs 34 million in FY06 to Rs 86 million in FY07. We expect advertising expenses to more than double y-o-y in FY08E further dragging EBITDA margins. On account of the fall in EBITDA margins and the increased depreciation and tax rates, the net margins have declined by 227 bps y-o-y to 5.1% in FY07.

Outlook

The stock has given a 51% return from our initiating coverage report dated July 12, 2006. We expect Zicom’s revenues to grow at 34% CAGR from FY07-09E, however on account of equity dilution (conversion of FCCB) and fall in margins we do not see upside to the stock at these levels. At the CMP of Rs 221, the stock trades at 33x our revised FY08E diluted EPS of Rs 6.7. Given the expensive valuations, poor return ratios, no growth in earnings over the next two years, we downgrade our recommendation from ‘BUY’ to ‘SELL’.

Preferential Issue to Bennett, Coleman and Co

Zicom has approved allotment of 5,00,000 equity shares of Rs 10 each in favour of Bennett, Coleman & Co at a price of Rs 200 per share aggregating Rs 100 million on preferential basis. This will enable the company to increase the visibility and create brand awareness thereby increasing sales over the next three years. The amount of Rs 100 million will be utilized by Zicom for their media spending through Bennett Coleman’s network.

Investment in Unisafe

Zicom has acquired 49% stake in Unisafe Fire Protection Specialists LLC, Dubai, by executing a Share Sale deed in May, 2007 with an existing partner of the said Joint Venture. Unisafe Fire Protection Specialists LLC, Dubai, a Limited Liability Company, has taken over business of an erstwhile partnership firm M/s. Unisafe Dubai. Unisafe has been engaged in providing fire protection products and services in U.A.E. for almost a decade. Unisafe has handled many prestigious projects in UAE like Emirates Towers, Dubai Airport Hangars, etc. Its clientele includes the government, corporate, refineries, shopping malls, multi storey building, resorts etc. It offers a comprehensive range of solutions for all Fire Protection needs starting from the basic Hydrant and Sprinkler Systems to advance Analogue Addressable Fire Alarm Systems and specialized Gaseous Fire Suppression Systems. Unisafe recorded sales of Rs 390 million in FY06 (November ended) with losses at the net level. Though the management expects this JV to have sales of Rs 650 million next year, we are apprehensive about its profitability. We have assumed profits from the investment in JV as other income.

Tie-up with Future group

Zicom has entered into a strategic tie-up with Future Media for retailing its products from exclusive Zicom retail counters placed in 100 outlets of Future Group's select retails formats. These formats include Big Bazaar, Brand Factory, Collection I, Central, E Zone, Electronic Bazaar, Food Bazaar, Furniture Bazaar, M Port, WSC, etc. In the sector of electronic security systems, the Company is the first Company to introduce display counters in such retail formats, kiosks for its consumers. We expect sales of Rs 140 million over the next two years from this tie-up.

Possibility of further equity dilution

Zicom has passed enabling resolutions to issue securities not exceeding USD 35 million or equivalent thereof in Indian Rupees by way of Foreign Currency Convertible Bonds and/ or Global Depository Receipts and/or Other Foreign Securities / Instruments convertible into or linked to equity.

Outlook

Although we remain bullish on the electronic security industry we don’t see any upside to the stock. Given the muted EPS growth, fall in margins, non accrual of service revenues from video & central monitoring services, we believe that the stock looks expensive. We downgrade our recommendation from ‘BUY’ to ‘SELL’.